If you are looking to invest in individual stocks in 2015, you are going to want to look at the fundamentals of the company in order to know if it is a potentially good investment. Of course, there is always going to be uncertainty in the markets, but by taking a look at companies which analysts identify as an “economic moat,” you can hedge your risk of investment.
The Competitive Advantage
When you hear the word ‘moat’, you probably immediately think of a medieval castle with water surrounding it. Well, it is sort of the same idea for an economic moat — relating that moat figuratively to finance.
An economic moat is a type of maintainable competitive advantage that a business has that makes it difficult for competitors to diminish its market share and profit. The term actually does come from the water filled moats that surrounded medieval castles. The wider the moat, the more difficult it would be for an invader to reach the castle. And in the financial sense, the wider the economic moat, the harder it is for competitors to be a threat in the marketplace.
There are five areas which we look at to determine the economic moat of a business:
- Industry Competitors – Who are the company’s current competitors within the industry? What advantage does one company have over the others? Are service, product, and price similar to others?
- Threat of Substitute Products – Is there a product or service that can offer the consumer relatively the same function at a lower price? Competition within the industry naturally drives the formulation of substitute products. This however, can limit product profitability.
- Bargaining Power of Suppliers – Suppliers have a great deal of influence over an industry as they affect price increases and product quality. This is even more evident within an industry if it is subjugated by a few companies, there are no substitute products, the industry is not an important consumer for the suppliers, their product is essential to the industry, or the supplier differs costs.
- Bargaining Power of Buyers – Here is where we look at price verses demand. Not just in the traditional sense of consumer demand for a product, but buyer group demand. Buyer power is significant because they can force prices down, demand better quality in a product or service, and drive opposition between industry competitors. While individual consumers have this power, large-volume buyer groups make even more of an impact on pricing for a company.
- New Potential Entrants – Are there barriers for other companies to enter into this market? Porter identifies six major barriers to entry:
- Economies of scale, or decline in unit costs of the product, which force the entrant to enter on a large scale and risk a strong reaction from firms already in the industry, or accepting a disadvantage of costs if entering on a small scale.
- Product differentiation, or brand identification and customer loyalty.
- Capital requirements for entry; the investment of large capital, after all, presents a significant risk.
- Switching costs, or the cost the buyer has to absorb to switch from one supplier to another.
- Access to distribution channels. New entrants have to establish their distribution in a market with established distribution channels to secure a space for their product.
- Cost disadvantages independent of scale, whereby established companies already have product technology, access to raw materials, favorable sites, advantages in the form of government subsidies, and experience.
Here are a few companies with strong economic moat identifiers which analysts recognize as stable:
Morningstar’s review: Regeneron is a biotechnology company that we rate as having a narrow moat and a positive moat trend. We think its positive moat trend is driven by its recent string of clinical and commercial successes, as well as its very full and productive drug-development pipeline.
Morningstar has upgraded Mead Johnson: Brand Loyalty—Mead Johnson does nutrition for babies and toddlers and young kids. And once parents choose an infant formula, they are very loath to just switch–in fact, they become more of an early lifetime customer.
Morningstar has raised the moat rating from narrow to wide on this company. Allergan will be acquired by Actavis. Analysts think that as a combined entity, it has much stronger competitive advantages.
Facebook was up nearly 45% in 2014 and has proven that it can maintain users on mobile devices as well as it did on desktop computers. The company was also able to show that it can obtain good rates for ads.
Rick Summer, Morningstar’s Facebook analyst, thinks that shares look a little bit pricey right now, but he does say that given how much Facebook is investing in its future and in long-term growth, there is a chance that you could have a few quarters that don’t look so great–maybe the stock could sell off. “There might be an opportunity for a better entry point for investors sometime in the near future,” Summer stated.
Apple Pay is expected to be a game changer in the way that people pay for purchases in the future. Analysts like the strong fundamentals of this mobile payment platform. Because of Apple’s status, the iPhone comes equipped with an app for Apple Pay, which will make it easy for current customers to access and use.
Apple was also able to secure several merchants, credit card issuers, and card networks that are willing to integrate this payment platform. Apple Pay is also expected to offer stronger security and privacy than the magnetic stripes on plastic credit cards currently used today.
*The information provided in this article is for informational purposes only. It is in no way meant to be a specific investment recommendation. Before making any monetary investment, fully research for yourself or talk with your professional investment advisor about the company, mutual fund, or municipality in which you are looking to invest and understand the risk factors involved.